Written evidence submitted by Professor
Nicholas Barr, London School of Economics

Objectives

1. There is wide agreement about three major
objectives of higher education policy: quality, access and size.

2.A major distortion in the existing
system is the interest subsidy, which makes student loans expensive
in fiscal terms, with ill-effects that include the cap on student
numbers.

What the reform proposals get right

3. I have argued elsewhere (Barr, 2010a;
Barr and Shephard, 2010; Barr and Johnston, 2011) that, in pursuing
those objectives, the reforms are right in two important respects:

1) INCREASINGTHEFEESCAP over time brings more resources
into higher education and strengthens competitive incentives.

2) RAISINGTHEINTERESTRATEONSTUDENTLOANS reduces the fiscal cost
of the loan system, facilitating expansion of student numbers
and rectifying a highly regressive element in the current system.

4. These reform directions are both essential
elements in a strategy to liberalise student numbers, which in
turn is essential to achieving the core objectives. Relaxing the
numbers constraint:

 Directly
facilitates the size objective;

 Contributes
to access: if places are scarce, it is likely to be students from
disadvantaged backgrounds who are crowded out; and

 Contributes
to quality, since excess demand mutes the beneficial effects of
competition on quality.

What is wrong with the reform proposals

5. Three further elements in the reform proposals
largely or wholly negate these potential benefits.

3) ABOLISHINGTAXPAYERSUPPORT
(T GRANT) for most subjects ignores
the fact that higher education has social benefits in addition
to private benefits (Barr and Shephard, 2010, paras 6-19); the
resulting risks are that too few students will apply to university,
that quality will suffer, or both.

4) SUBSTANTIALLYINCREASINGTHEREPAYMENTTHRESHOLD.
Specifically, the proposal is to raise the threshold at which
loan repayments start from £15,000 per year to £21,000,
and to index the threshold to earnings. These changes significantly
erode the repayment performance of loans (Barr and Johnston, 2011).
The resulting high cost creates a fundamental problem. In the
current system the interest subsidy makes loans fiscally expensive,
hence the numbers cap. Under the proposed reforms the interest
subsidy problem is rectified but loans continue to be fiscally
expensive because of the large increase in the repayment threshold.
Thus the new system creates the same problem - the numbers cap
- for the same reason - the high cost of loans.

5) ABOLISHING
EDUCATION MAINTENANCE
ALLOWANCESAND
AIMHIGHER.
Though it is intuitively obvious that "free" higher
education widens participation, the view is mistaken. The evidence
is now very strong that the main impediment to participation is
the lack of prior attainment: people do not go to university because
they do not even get to the starting gate. The English record
on participation was shameful before fees were introduced, and
participation has improved sharply in recent years precisely because
policy focused on improving school results (HEFCE 2010). Abolishing
Education Maintenance Allowances and AimHigher is therefore profoundly
mistaken since both policies directly address problems of participation
at their source.

What solutions

6. The current proposals will not stand the test
of time. Barr and Shephard (2010) set out arrangements that put
things back onto a sound strategic basis, in particular:

 Restoring
some T grant as a block grant for each university, possibly tapered
so that institutions which charge lower fees receive more grant;
and

 Arranging
student loans so that (a) most graduates repay in full and (b)
the cost of the remaining loss falls on the taxpayer as little
as possible.

If these arrangements cannot be put into place during
the present round of reforms, they should form the basis of the
next round.

7. The bare minimum that should be done now is
to freeze the repayment threshold. Another short-run option which
is compatible with a longer-term strategy is to introduce university-specific
insurance premiums to cover at least part of the loss on loans.

8. FREEZETHEREPAYMENTTHRESHOLDAT £21,000 INNOMINALTERMSFORTHETIMEBEING.
Note that raising the threshold reduces monthly repayments most
for graduates earning £21,000 or more, less for graduates
earning between £15,000 and £21,000, and not at all
for graduates earning less than £15,000. Thus there is a
trade-off between indexing the repayment threshold, which gives
the smallest benefit to low earners, or freezing the threshold,
thus reducing the cost of loans and making it possible to allow
more people into the system. Put another way, the high threshold
benefits insiders whereas a lower threshold, facilitating expansion,
benefits outsiders. A threshold of £21,000 (or less) contributes
more to access and expansion than indexing the threshold to prices,
let alone to earnings.

9. INTRODUCEAUNIVERSITY-SPECIFICINSURANCEPREMIUM,
at least for students in excess of the HEFCE quota. In this arrangement,
universities would be allowed to increase student numbers on the
basis that each university pays an insurance premium that covers
the non-repayment of loans by its graduates. The previous paragraph
noted that a high threshold makes loans expensive; this is equally
true for universities. Thus lowering the repayment threshold is
relevant not only to the exchequer but also to Vice-Chancellors
- the choice of loan threshold and the ability to have off-quota
students at low or zero cost to the Treasury are linked.

10. Why, in conclusion, does fixing an incontinent
loan system matter? This is not a matter of ideology, but deeply
practical. Fixing the loan scheme is essential to relax numbers
constraints, which in turn is necessary to achieve the three core
objectives. Doing so would also make it possible to liberalise
the availability of loans to part-time students (on which a commendable
start is being made) and to offer loans to postgraduates (an inexplicable
and mistaken omission in the reform proposals).

1. This submission responds to the proposals
of the Browne Review (Independent Review of Higher Education Funding
and Student Finance, 2010) and the government's response. It argues
(Section 2) that the reform proposals are right in that they:

1) Raise the fees cap, and

2) Raise the interest rate on student loans,
but wrong (Section 3) in in that they:

3) Abolish taxpayer support for teaching (the
T grant) for most subjects;

4) Make the loan repayment terms too generous;
and

5) Abolish Education Maintenance Allowances and
AimHigher.

The latter three elements largely negate the gains
from the first two. Section 4 summarises recommendations.

1. THE BACKDROP

1.1 Objectives

2. The analysis that follows is based on a series
of arguments:

 Human
capital matters, to meet the technologically-driven increase in
the demand for skills (Appendix 1);

 Competition
is beneficial in helping higher education to meet the needs of
students and employers (Appendix 2).

3. Higher education matters because knowledge
for its own sake is important, as is the transmission of core
values. To that extent, nothing has changed. In contrast with
earlier years, however, higher education now matters also for
national economic performance and for individual life chances.

4. More specifically, the major objectives policy
for higher education are taken to be:

 Quality
(improving);

 Access
(widening);

 Size,
to eliminate excess demand for university places.

5. The third objective is often overlooked. Achieving
the objective is important, first, to ensure that Britain invests
sufficiently in skills. Size also assists access: if there is
a shortage of places, the likelihood is that the most disadvantaged
will be crowded out. Size is relevant also to achieving the quality
objective. The strategy for improving quality has three elements:
competition, robust quality assurance, and eliminating
the shortage of places. The last is central. In a competitive
market, if the quality of university X declines, the effect is
to reduce demand, creating downward pressure on quantity and price
(ie fewer students, paying lower fees). Excess demand for places
largely negates those pressures.

6. If competition is to have beneficial effects
on quality, excess demand for university places has to be eliminated.
In principle this could be done by (a) allowing fees to rise enough
to choke off excess demand, or (b) allowing the supply of places
to increase. Given the centrality of human capital to national
economic performance, option (a) is a thoroughly bad one. What
is needed is an increase in supply. I am not recommending completely
liberalising student numbers, but that any control of numbers
should be considerably more muted than at present.

7. All political parties agree with the objectives
in paragraph 4; so do virtually all commentators. My twofold criticism
of the proposed reforms is very simple:

 They
will fail to achieve those objectives;

 With
the modifications described in Section 3, they could achieve those
objectives.

1.2 The 2006 reforms: a genuine strategy

8. ECONOMICTHEORY
points to three lessons (discussed more fully in Barr, 2004; 2010a)
which should shape the finance of higher education:

 Competition
is beneficial (Appendix 2);

 Graduates
(not students) should contribute to the cost of their degrees
for the reasons discussed more fully in section 3.1; and

 Well-designed
loans have core characteristics: in particular, loans should have
income-contingent repayments, should be large enough to cover
fees and living costs, so that higher education is free, or largely
free, to the student, and should charge an interest rate related
to the government's cost of borrowing. The ill-effects of violating
the last point are discussed in section 2.2.

9. These lessons suggest a strategy with three
elements.

 Variable
fees: universities are financed from a mix of taxation and tuition
fees. Each institution sets its own fees. Fees give institutions
more resources to improve quality and, through competition, help
to improve the efficiency with which those resources are used.
Students, however, generally cannot afford to pay fees, hence
the second element.

 A good
loan system: student support is through loans with income-contingent
repayments and large enough to make higher education largely free
at the point of use.

 Active
measures to widen participation: if the world comprised only middle-class
students, the first two elements would suffice. Since that is
very far from the case, the third element, discussed more fully
in section 3.3, addresses participation.

10. THE 2006
STRATEGY was based on the analysis
in the previous two paragraphs.

 Fees.
The 2004 Higher Education Act replaced the previous upfront, centrally-set
flat fee by variable fees. In contrast with the earlier regime,
fees are covered by a loan, and so can be deferred until the borrower
starts to earn.

 Loans.
The previous system provided a maintenance loan, with income-contingent
repayments of 9% of income above £10,000. There was no loan
to cover fees, and the maintenance loan was too small. The reforms
introduced a loan to cover fees, increased the size of the maintenance
loan, and raised the threshold at which repayments start to £15,000
per year. Any loan that remains unpaid after 25 years is forgiven.
The maintenance loan and fees loan charged a zero real interest
rate.[23]

 Policies
to widen participation. The reforms restored
maintenance grants, required universities to provide bursaries,
and established an Office for Fair Access. Importantly, other
reforms tackled inequalities earlier in the system.

2. WHAT'S
RIGHT

2.1 Why it is right to raise the fees cap

11. WHYFEES?
The argument for fees is threefold.

 Affordability:
fiscal constraints make it impossible for the taxpayer to finance
a large, high-quality system of higher education. Fees bring in
additional resources for the university system.

 Efficiency:
variable fees, by strengthening competition, help to create incentives
to use those additional resources efficiently.

 Equity:
since it is disproportionately students from better-off backgrounds
who go to university, undue reliance on taxpayer finance is regressive.

12. WHYHAVEAFEESCAP. Though the case for variable
fees is strong, there are reasons for establishing a maximum level
of fees, ie some form of price control. In the short term, the
cap needs to be high enough to bring in extra resources and, by
strengthening competition, to improve the incentives to use those
resources efficiently, but low enough to maintain long-term political
support for the strategy and to allow institutions less used to
competition the time to develop the necessary management capacity.

13. There is an additional, longer-term argument.
Though universities compete in terms of teaching, some universities
are also selling access to the student's network of peers and,
in this latter respect, have an element of monopoly power. Such
monopoly power, it can be argued, is part of the explanation for
the very high level of fees at some US universities. The resulting
monopoly rent is not distributed to shareholders but ploughed
back into facilities, a distortionary upward bias on spending
which, it can be argued, leads to quality which is inefficiently
high.[24]

14. WHYITISRIGHTTORAISETHEFEESCAP. The cap of £3,000 was
too low: it brought in useful additional resources, but not enough,
and led to a situation where there was no variation in price,
muting competitive incentives. Thus the increase in the fees cap
is right, though, as argued below, the abolition of taxpayer support
for teaching in most subjects (section 3.1) and faulty loan design
(section 3.2) call into question whether the extent of the increase
was right.

2.2 Why it is right to raise the interest rate
on student loans

15. WHYLOANS?
The argument for income-contingent loans is set out in evidence
to the Education and Skills Committee (Barr, 2002) and the Browne
Review (Barr, 2010a). They bring in private resources on
a substantial scale, but in a way that provides automatic protection
for low earners. There are good reasons for having a loan rather
than a graduate tax, discussed more fully in Barr (2010b),
including:

 Public
money: a tax is irredeemably public finance, ruling out net private
finance until the present value of cumulative repayments by graduates
outweighs the relevant cumulative upfront outgoings by government.

 Closed-ended
finance: with a graduate tax, the Treasury continues to control
the funding envelope; thus institutions compete for resources
in a zero-sum game.

 Fails
to foster quality because competitive pressures are muted.

 A closed-economy
model: it is not possible to collect repayments from EU students
who subsequently work outside the UK, nor from UK graduates working
abroad.

16. WHATISWRONGWITHINTERESTSUBSIDIES?
The intuition of interest subsidies is clear but mistaken. With
conventional loans an interest subsidy would, for example, help
first-time house buyers by reducing monthly repayments. Income-contingent
repayments turn the argument upside down: if a person's repayment
is x% of her earnings, a lower interest rate has no effect
on monthly repayments, but instead shortens the repayment period.
Consider a person who repays his or her loan after 10 years with
a zero real rate, but takes 12 years with an interest rate equal
to the government's cost of borrowing. The higher interest rate
has no effect on monthly repayments until the later years of the
loan (in this example years 11 and 12), when repayments continue
when otherwise they would have stopped.

17. The efficient
interest rate should be related to the cost of finance, for example,
the government's borrowing rate. Charging an interest rate below
the government's cost of borrowing creates a blanket interest
subsidy. For the reasons set out in Box 1, that subsidy is inimical
to all the core objectives.[25]

Box 1: What is wrong with interest subsidies

When loans have income-contingent repayments and
forgiveness of any loan balance that remains outstanding after
(say) 25 years, interest subsidies have not a single virtue and
many vices.

Cost. The interest subsidy is expensive in fiscal
terms. There are at least three reasons why the high cost should
not be surprising:

 The
subsidy applies to all borrowers for the whole loan and for the
entire duration of the loan. Thus not even the best-paid graduates
repay their loans in full.

 The
duration of repayments is long; this is desirable, since it is
efficient if the length of a loan is related to the life of the
asset, hence three-year car loans but 25-year home loans. But
with an interest subsidy, the longer the loan, the more costly
the subsidy.

 Borrowers
face an incentive to arbitrage: students who do not need the money
borrow as much as they can and save the money, making a profit
on the interest rate.
These high costs lead to further ill effects.

Impediments to quality and size.
Student support is often politically more sensitive than direct
spending on universities. Within a given budget, the cost of the
interest subsidy crowds out finance for teaching and research,
putting quality at risk. More dramatically, the cost of the interest
subsidy is one of the direct causes of the current shortage of
places.

Impediments to access.
Because loans are expensive, they are rationed in size or number.
They may not cover tuition fees; or they cover only part of living
costs; or they may exclude some groups, for example, part-time
and postgraduate students, and students in non-university tertiary
education. The effect is most likely to harm students from poor
backgrounds, who are less likely to have access to family support.

Regressive. Interest subsidies
do not help students (graduates make repayments, not students).
They help low-earning graduates only slightly: people with low
earnings make low or no repayments; and if earnings remain low
over the long term, unpaid debt is forgiven. Interest subsidies
do not help high-earning graduates with low earnings early in
their career, since with income-contingent loans, their monthly
repayments will be low; the interest rate affects only the duration
of the loan. Thus the major beneficiaries are successful professionals
in mid-career, whose loan repayments are switched off (say) after
10 years rather than after (say) 12 years with a higher interest
rate. This is not the group that the policy was intended to help.

18. EMPIRICALEVIDENCE. Figure 1 shows estimates
of non-repayment of loans by decile of the lifetime earnings distribution,[26]
and illustrates the important distinction between two sources
of redistribution.

 Forgiveness
after 25 years (the darker shading): this part of the system,
which benefits people with low lifetime earnings, is well-targeted
social policy spending and a deliberate feature of the system.

 The
interest subsidy (the lighter shading): this part of the system
benefits people who repay their loan within 25 years. This subsidy,
given 25 year forgiveness, has all the disadvantages outlined
above and no offsetting advantages.

The figure shows how forgiveness after 25 years
(the darker shading) mainly benefits the lowest earners. Since
women on average have lower lifetime earnings than men, forgiveness
after 25 years mainly benefits female graduates. In contrast,
the zero real interest rate (the lighter shading) benefits graduates
in medium and higher deciles of male earners almost as much as
those in lower deciles. There are gains also for earners in the
upper deciles of the female earnings distribution. The results
show clearly that not even the highest graduate earners repay
in full in present value terms.

3. WHATIS
WRONGANDWHATSHOULDBEDONETO FIXIT?

20. Raising the fees cap and increasing the interest
rate on student loans reduces the taxpayer cost of higher education,
contributes to efficiency, and is progressive, and thus facilitates
quality, access and size.

21. Other elements in the reform package, however,
largely negate these potential gains. This section points to three
sets of problems:

 Insufficient
taxpayer support for teaching, with potential harmful effects
on numbers of students applying and/or on quality (section 3.1);

22. The reforms propose that taxpayer support
for teaching the arts and humanities and the social sciences (the
"chalk and talk" subjects) should be largely abolished.
This is mistaken because it ignores the external benefits of higher
education.

23. Economic theory argues that where an activity
generates benefits to society over and above those to the individual,
a pure market will lead to too little of that activity taking
place. A person who pays to be vaccinated against measles benefits
personally because he will not get measles (the private benefit)
but also confers a benefit on others because they will not catch
measles from him (the external benefit). In the absence of a subsidy,
too few people will choose to be vaccinated. The same argument
applies to higher education, which creates external benefits in
the ways set out in Box 2.

Box 2: The external benefits of higher education

Education creates external benefits in a range of
ways.

Future tax payments. If
education increases a person's future earnings, it increases her
future tax payments. Her investment in education thus confers
a "dividend" on future taxpayers. In the presence of
such an externality, the resulting flow of investment will be
inefficiently small. A standard solution is an appropriately designed
subsidy. For precisely that reason, most countries offer tax advantages
for a firm's investment in physical capital.

Production benefits arise
if education makes someone more productive, and also makes others
more productive. Individuals may become more adaptable and better
able to keep up with technological change. The economic spin-offs
of an occupationally mobile population are relevant in this context.
It is not surprising that much high-tech industry occurs in clusters
near leading universities, like Silicon Valley, Cambridge (Massachusetts),
and Cambridge (England), and education lies at the heart of endogenous
growth theory.

Cultural benefits. Education
can create cultural benefits in the form of better parenting,
through increased civic engagement and, though harder to document,
by strengthening tolerance of diverse views.

24. That some of these externalities are hard
to measure does not make them unreal. The first is unambiguous.
As regards growth effects, the case for widening and deepening
human capital is not simply as investment, but also as insurance
(the risk of under-investing is that of being overtaken by South
Korea).

The problem

25. When deciding whether or not to go to university
people consider only their private benefit. As a result, in the
absence of a subsidy, demand will be below its efficient level.
Abolishing taxpayer support for teaching (the T grant) in the
arts and humanities, and the social sciences risks precisely that
effect. Specifically, the absence of any subsidy risks either
or both of two outcomes:

 If
universities increase fees by the full amount of the withdrawn
subsidy, the risk is that too few students will apply;

 If
universities do not increase fees to cover the lost subsidy, the
risk is an inefficient reduction in quality.

26. Why was this policy adopted? There are good
grounds for arguing that a major reason for replacing T grant
by loans is that, for technical reasons, the change reduces PSBR.
The reasoning (Box 4) is explained most easily as part of the
discussion of student loans, in section 3.2.

What should be done

27. The simple solution is to restore T grant
at a level between zero and the current level but, to control
public spending, to award it as a block grant to each university.

28. A more sophisticated approach (Barr and Shephard,
2010) notes that though the externality argument for subsidies
is generally correct, it does not hold where demand is price inelastic,
ie where the number of people applying to Oxbridge would change
little, if at all, if fees increased by, say, £1,000, whereas
a fee increase of that size would have a major impact on the demand
for places at Balls Pond Road University. In that case, the absence
of a subsidy for Oxbridge does not reduce demand, hence there
is no efficiency loss, hence no case for a subsidy. This does
not imply that there is no social benefit, merely that there is
no efficiency reason for subsidising its production.

29. Building on that logic, Barr and Shephard
(2010) propose a tapered T grant, awarded as block grant, such
that universities charging a low fee receive the maximum T grant
and universities that charge high fees receive no T grant, with
a taper for intermediate fee levels.

30. The idea behind this arrangement is that
that price elasticity at a university charging high fees is likely
to be low, while that at a university charging low fees is likely
to be higher. Thus far the argument is an efficiency one. In addition,
for equity reasons, there should be a pupil premium payable for
each disadvantaged student, independent of university. The premium
could be paid to the university as additional income, creating
an incentive to recruit students from disadvantaged backgrounds,
or to the student, acting as a scholarship by paying a fraction
of fees upfront.

31. In the resulting system:

 Oxbridge,
charging £9,000, receives no T grant, but receives a pupil
premium for each disadvantaged student (at Oxbridge such students
would be the minority).

32. BOTTOMLINE.
Some T grant, awarded as block grant, should be restored. If this
is not possible immediately, the policy should be a priority for
spending on higher education as soon as the fiscal situation permits.

3.2 Why the changes to student loans are mistaken

33. The reforms propose that the threshold at
which loan repayments start should be increased from £15,000
to £21,000 and that that threshold should be indexed
to earnings. The reforms also propose that any loan that has not
been repaid after 30 years (rather than 25 currently) should be
forgiven.

The problem

34. The high repayment threshold has three strategic
ill-effects: the high fiscal cost of loans, the incentives to
universities to charge higher fees, and the fact that the distributional
effects are not as progressive as presented.

35. THEHIGHFISCALCOSTOFLOANS.
Raising the repayment threshold from £15,000 to £21,000
is expensive because the change reduces monthly repayments not
only for someone earning £20,000, but also for someone earning
£100,000. Someone earning £21,000 repays £540 less
per year (ie 9% of £6,000) under the proposed system than
under the current system, and anyone above £21,000, however
high their earnings, also repays £540 less per year. Thus
monthly repayments are lower for most graduates, including the
highest earners, which is expensive. Box 3 explains how that cost
is measured.

36.

Box 3: The RAB charge: student loans in the
accounts

Suppose that total lending to students this year
is £3 billion, and that it is estimated that 30% of total
lending to students will not be repaid. Student loans are off
budget. Thus the 70% of lending that will be repaid, ie £2.1
billion, is not included in public spending as measured by PSBR.
However, the estimated non-repayment, £900 million, appears
in the BIS budget as current spending - the Resource Accounting
Budget (RAB) adjustment. In short, the RAB adjustment represents
the cost of loans that the government estimates will not be repaid,
ie the loss on the loan system. For fuller discussion, see Barr
and Johnston (2010, Annex 1).

37. Thompson and Bekhradnia (2010) (see also
Chowdry et al.,2010b) point out that the government's estimates
of the RAB charge under the proposed new arrangements are very
sensitive to assumptions about the average level of fees (and
hence the size of the average loan), and to the growth of real
earnings (and hence repayment performance), and conclude that
the underlying assumptions are optimistic.

38. The high cost of loans creates a fundamental
problem. In the current system the interest subsidy makes loans
fiscally expensive, distorting higher education policy in various
ways, in particular the numbers cap. Under the reform proposals
the interest subsidy problem is rectified but loans continue to
be fiscally expensive because of the large increase in the repayment
threshold, plus indexing that threshold to earnings. Thus the
new system creates the same problem - the numbers cap - for the
same reason - the high cost of loans.

Box 4: The effect on measured public spending
of replacing T grant by loans

Suppose that the T grant is £4,000, and that
30% of student lending is not repaid (ie a RAB charge of 30%).

The T grant is unambiguously public spending. A million
students each attracting a T grant of £4,000 increases PSBR
by £4 billion.

A loan of £4,000 increases PSBR by £1,200
(the RAB charge). One million students taking out the extra loan
increases PSBR by £1.2 billion.

Bluntly, what is going on is an accounting trick.
There is an apparent decline in public spending (though even that
might be an over-estimate), but at the cost of distorting higher
education policy.

39. THEINCENTIVETOUNIVERSITIESTOCHARGEHIGHERFEES.
As well as being expensive, the higher threshold creates an upward
bias in fees. Graduates of Balls Pond Road University tend to
be at the lower end of the graduate earnings spectrum, those of
Oxbridge at the higher end. Under the proposed arrangements, the
non-repayment of loans by Balls Pond Road University's graduates
does not fall on Balls Pond Road University but on taxpayers generally.
Thus all universities have an incentive to charge £9,000,
since the costs of non-repayment fall on others (Smith and Smith,
2010 illustrate the point by considering a degree with £9,000
fees targeted at old-age pensioners).

40. DISTRIBUTIONALEFFECTS. The restriction in student
numbers tends to harm students from less well-off backgrounds.
As discussed, the increase in the repayment threshold reduces
loan repayments by £540 per year for all graduates earning
above £21,000. Those earning below £21,000 (presumably
the intended beneficiaries of the change) benefit least: someone
earning £17,000 repays £180 less per year (ie 9% of
£2,000); someone earning £15,500 repays £45 less
per year; and anyone earning below £15,000 does not benefit
at all. Thus increasing the repayment threshold is (a) expensive
and (b) gives the least benefit to low earners; and indexing the
threshold to earnings retains this regressive pattern.

What should be done

41. Barr and Shephard (2010, paras. 23-29) discuss
improving the design of the loan system in three ways, which can
be used together or separately.

 Element
1: reduce the total loss on loans by reducing the repayment threshold,
at a minimum keeping the threshold of £21,000 constant in
nominal terms.

 Element
2: reduce or eliminate the taxpayer cost of loans by sharing the
cost of remaining non-repayment between:

 The
national cohort of graduates, eg charging an interest rate 1%
above the government's cost of borrowing, thus extending the duration
of repayments, and/or

 The
university: the charge could be levied in respect of borrowing
by all of the university's students in a given year, or only for
students above the institutional quota. Thus if Oxbridge charges
fees of £9,000, the SLC would pay Oxbridge a fee for such
students of £(9,000 - X), where £X is an estimate of
non-repayment of loans by Oxbridge graduates for fees of £9,000,
ie the Oxbridge RAB charge (see Box 3) for fees of £9,000.

The following discussion looks at each of these approaches
in turn.

42. MAKINGLOANSLESSLEAKY.
Barr and Johnston (2011) estimate of the potential magnitude of
the savings from keeping the £21,000 threshold constant in
nominal terms. Our benchmark is the current system with a repayment
threshold of £15,000 and a zero real interest rate, and assuming
a total loan per student over three years of about £26,000.
Our starting point (updated from Barr and Johnston, 2010) is an
estimate that, averaged across all borrowers, non-repayment is
25.8% of borrowing in present value terms, ie about £6,800
per student. This cost is the source of the current numbers cap.

43. The reforms (a) lead to larger loans, (b)
have a higher repayment threshold indexed to earnings and (c)
a higher interest rate. Elements (a) and (b) add to the fiscal
cost of loans, element (c) reduces the fiscal cost. The government's
estimates suggest that these effects roughly offset each other
so that the cost of the system remains broadly constant (though
note the earlier caveat about optimistic assumptions). Barr and
Johnston (2010) assume an average fee of £8,000, and consider
a system with a repayment threshold of £21,000 fixed in nominal
terms and a real interest rate of 3%, but with a safeguard for
low earners such that real debt is allowed to rise during university
years but not thereafter. We estimate that, compared with the
present system, the savings from freezing the £21,000 threshold
in nominal terms would be 15.7% of lending, or £2,218 per
student, and larger if fees on average are higher than our assumption
of £8,000. It is important to note that these are the savings
for the cohort of students starting in 2012. The savings for later
cohorts would be larger. The overall distribution of the change
is progressive (Barr and Johnston, 2011, Figure 1a).

44. The reform proposals give an interest subsidy
to graduates with low current income, even if they have high lifetime
income. This feature adds to the cost of loans and reduces the
progressivity of the system. As a more radical option for the
future, it would be both desirable in policy terms and feasible
administratively to award interest subsidies only to people with
low lifetime income.[27]

45. In sum, there is a trade-off between indexing
the repayment threshold, which gives the smallest benefit to low
earners, or retaining a constant nominal threshold, thus reducing
the cost of loans, hence making it possible to allow more people
into the system.[28]
Keeping the threshold of £21,000 contributes more to access
and expansion than indexing the threshold to prices, let alone
to earnings.

46. With the right repayment threshold and interest
rate, most graduates would repay their loans in full. However,
the combination of income-contingent repayments (to protect graduate
with low current earnings) and forgiveness after 30 years (to
protect graduates with low lifetime earnings) makes a loss by
design. To relax the numbers constraint, that inherent loss should
fall on the taxpayer as little as possible. As noted, the costs
could be imposed on graduates and/or on universities.

47. A NATIONALCOHORTRISKPREMIUM. Under this approach,
higher-earning graduates who have taken out a student loan pay
at least part of the loss on the loans of low earning graduates.
This is done on a national basis so that on average there is a
cross-subsidy from Oxbridge graduates to Balls Pond Road University
graduates. The idea is explored in more detail in Barr (2010c).

48. This arrangement, however, gives all universities
an incentive to charge £9,000, since neither the university
nor its low-earning graduates face the resulting costs. Thus a
cohort risk premium is only part of the story. What is needed
in addition is:

49. UNIVERSITY-SPECIFICINSURANCE. In this approach each
university pays an insurance premium calculated actuarially to
match the predicted loss on the borrowing of its students, thus
removing the incentive for all universities to raise fees to £9,000.

50. The idea of university-specific insurance
could be part of a reform of the entire loan system, or it could
be used only on the margin. One option would be to allow universities
to accept students beyond their HEFCE allocation at no cost to
the taxpayer, on the basis of a university-specific RAB charge.
Thus some (all) universities could take more than their quota,
provided that each university pays the government £X, where
X = that university's RAB charge for the loans taken up by that
year's off-quota students.

51. Note that (a) an increase in fees leads to
an increase in the size of loans taken out and (b) the percentage
loss on loans rises with the size of the loans. Thus higher fees
lead to a disproportionate increase in the loss on loans. University-specific
insurance has the advantage of providing a countervailing incentive
to raising fees.

52. A loan with a high repayment threshold is
expensive in fiscal terms. But, for precisely the same reason,
it would be expensive also for Oxbridge. Thus lowering the repayment
threshold is relevant not only to the exchequer but also to universities
- the choice of loan threshold and the ability to have off-quota
students at zero cost to the Treasury are linked.

53. The approach of off-quota students eligible
for a loan works best for universities whose university-specific
RAB charge is fairly low. The RAB charge is the result of (a) graduate
earnings and (b) the size of loan. Thus the approach works best:

 For
Oxbridge, whose graduates have high employment rates and high
earnings; and

 For
small loans, eg for some part-time students an offer to pay fees
loans only.

54. BOTTOMLINE.
Why does fixing an incontinent loan system matter? This is not
a matter of ideology, but deeply practical. Fixing the loan scheme
is essential to expand undergraduate numbers, which in turn is
necessary to achieving the core policy objectives. Cheaper loans
also make it possible to continue to trend to offering loans to
part-time students, and to extend loans to postgraduate students
(given the pressures of international competition, failure to
offer loans to this latter group is a serious error).

55. To those ends, at the very minimum, the threshold
of £21,000 should be kept constant in nominal terms for the
time being.

3.3 The real policies to widen participation

56. BARRIERSTOPARTICIPATION.
It is often argued that it is obvious that "free" higher
education widens participation. But the evidence suggests something
very different. The central causes of failure to participate are
twofold: the prior-attainment constraint and the liquidity constraint.
For most students a good system of loans and grants addresses
the latter. Beyond that, to anyone who is serious about the evidence,
one message stands out - it's school attainment, stupid.
As a researcher into early child development tragically put it,
"By the time they are 18, all the damage has been done".[29]
In 2002 (when students from poor backgrounds paid no fees), 81%
of children from professional backgrounds went to university;
the comparable figure for children from manual backgrounds was
15%[30]
- a shameful record. Yet restricting the sample to young people
with good A levels, the figure was roughly 90% for both groups.

57. THERIGHTPOLICIESTOWIDENPARTICIPATION.
What does this imply for policy that really starts to improve
participation (for fuller discussion, see Chowdry et al. 2010a)?

 Policies
to improve attainment in school: access fails when someone leaves
school at 16, usually for reasons that started much earlier. There
is ample evidence of the huge importance of early child development.
A central element in widening participation is to strengthen pre-university
education, from nursery school onwards.

 Policies
to increase information and raise aspirations: such policies include
AimHigher. They should also include better advice of subject choice
both for GCSE and A levels - advice both for pupils and for teachers.
A further element is better explanation of how higher education
finance works for the student, an area which for many years has
been woeful. It is important to get across to prospective students
and their parents that higher education is largely free to the
student - it is graduates who repay, and that student loan repayments
are a payroll deduction, not credit card debt. Saying much the
same thing, from the viewpoint of the individual graduate, loan
repayments are identical to a graduate tax, but one that is eventually
switched off.

 More
money: policies include the current system of Education Maintenance
Allowances, to encourage people to stay on at school, and grants
and bursaries. I am not opposed to grants and bursaries, but deeply
opposed to policy that assumes that they are all that is
necessary. Grants and bursaries, though important, are the tail;
it is attainment in school that is the dog.

58. Many activities cover more than one of these
elements. And many are already happening but should be increased:
mentoring of schoolchildren by university students, visit days,
Saturday schools, summer schools, winter schools, and the like.
The major purpose of such activities is to demystify university,
to give schoolchildren sources of information that are authoritative
(university teachers) and with street cred (student mentors).

59. The focus on tackling participation by action
earlier in the system is already bearing fruit.

"Substantial, sustained and materially significant
participation increases for the most disadvantaged areas across
the 04:05 to 09:10 cohorts are found regardless of whether educational,
occupational or income disadvantage is considered. Typically,
young people from the 09:10 cohort living in the most disadvantaged
areas are around +30% more likely to enter higher education than
they were five years previously (04:05 cohort), and around
+50% more likely to enter higher education than 15 years previously
(94:95 cohort)" (HEFCE, 2010, para. 28, emphasis added).

"Trends in social statistics - such as HE participation
rates - that are associated with deeply rooted differences in
advantage do not usually show rapid change. A set of robustness
and credibility checks give confidence that the analysis in this
report is faithfully describing HE participation trends. In particular,
the unusually rapid increases in HE participation recorded
since the mid-2000s for young people living in disadvantaged areas
are supported by changes in the GCSE attainment of the matching
cohorts of young people ." (ibid., para. 31,
emphasis added).

60. THEWRONGPOLICIES.

 Abolishing
Education Maintenance Allowances and AimHigher - the policies
which directly address problems of participation at their source
- is the most egregious error.

 Excessive
focus on grants and bursaries: since impediments to participation
arise long before someone starts at university, undue focus on
grants targets resources at the wrong part of the problem. The
error is not just an exercise in academic logic chopping. It makes
the wrong diagnosis and therefore leads to the wrong prescription.
It spends money on "free" higher education rather than
improving earlier education, and thus spends money on a policy
that does not work. "Free" higher education - the system
in Britain for 40+ years - produced the shameful participation
figures already mentioned.

 Excessive
focus on loan repayments, leading to the counter-productive increase
in the loan repayment threshold.

4. CONCLUSION

61. The advances discussed in section 2 - a higher
fees cap and a real interest rate on student loans - are both
essential elements in a strategy to liberalise student numbers,
which itself is an essential element in achieving the three objectives
- quality, access and size - set out at the start of this submission.
Unfortunately, the proposals discussed in section 3 mean that
the reforms will not achieve those objectives. The continuing
high cost of loans has two strategic ill effects.

 Student
numbers will continue to be capped, so that significant excess
demand for university places will remain. That excess demand is
bad not only for direct reasons, but also because it mutes the
competitive incentives which contribute to the quality objective.

 Loans
will gobble up resources that should be used - mainly earlier
in the system - to widen participation, thus accentuating the
ill-effects arising from the abolition of Education Maintenance
Allowances and AimHigher.

Thus the reforms will not achieve the objectives
of quality, access and size. It can be argued that overall little
will change: on the one hand, higher headline tuition fees may
have a small negative effect; on the other, unless the numbers
cap is significantly relaxed, excess demand for places will continue.

62. WHATNEEDSTOBEDONE, IFNOTNOWTHENINTHEROUNDOFREFORM.

 Restore
at least some T grant, arranged as a block grant, perhaps tapered,
so that universities that charge lower fees receive a larger T
grant, as discussed in section 3.1; for fuller discussion, see
Barr and Shephard (2010, paras. 6-19).

 Reform
the loan system so that its fiscal costs are as small as possible:

 Over
time reduce the real threshold at which loan repayments start
(Barr and Johnston, 2011);

 As
far as possible, relieve the taxpayer of the remaining loss on
loans, which should be shared between the cohort of graduates
(through a national cohort risk premium) and universities (via
a university-specific RAB charge), as discussed in section 3.2
(for fuller discussion, see Barr and Shephard, 2010, paras 20-29).

These reforms to the loan system make it possible
to liberalise student numbers, to extend the availability of loans
to part-time students, and to offer loans to postgraduates.

 Divert
resources to address the real impediments to participation. Rather
than require universities to pay large bursaries, encourage them
to contribute to the finance of remedial reading in inner-city
primary schools.

63. WHATISTHEBAREMINIMUMTHATSHOULDBEDONENOW

 Freeze
the £21,000 threshold in nominal terms for the time being
(Barr and Johnston, 2011).

 Consider
introducing a university-specific insurance premium, at least
for students in excess of the HEFCE quota.

22 May 2011

APPENDIX 1

HUMAN CAPITAL MATTERS

There are at least two strategic sets of arguments
emphasising the importance of investment in skills.

Technological advance
is a key driver. First, though it can reduce the need for skillsfor
example, computers have become more user-friendlytechnological
advance mostly increases the demand for skilled workers and reduces
the demand for unskilled workers. The evidence points to skill-biased
technical change (ie new technologies that favour more skilled
workers) being an important part of the explanation.

Secondly, change is increasingly rapid, so that knowledge
has a shorter half-life: thus skills need to be updated, and need
to be flexible enough to adapt to changing technology. Put another
way, investment in broad, flexible skills offers a hedge against
technological dynamism. Specific skills may become redundant,
but education and training should give people general skills,
saving the resources that would otherwise have to be devoted to
retraining labour whose skills had become outdated or, at worst,
to supporting workers socially excluded as a result of technological
advance.

A separate argument is that widening and deepening
human capital should be seen not only as investment, but also
as insurance against being overtaken by countries with greater
investment in skills.

These changes explain the movement into the "information
age", meaning a need for education and training that is (a)
larger than previously, (b) more diverse, and (c)
repeated, in the sense that people will require periodic retraining.

Demographic change creates a second argument. The
rising proportion of older people in many countries presages high
spending on pensions and other age-related activities such as
medical and long-term care. The solution is to increase output
sufficiently to meet the combined expectations of workers and
pensioners. If the problem is that workers are becoming relatively
more scarce, the efficient response is to increase labour productivity.
Demographic change is thus an argument for additional spending
on investment both in technology and human capital.

APPENDIX 2

COMPETITION IN HIGHER EDUCATION IS BENEFICIAL

In most countries, higher education has, in essence,
been centrally planned. The case against this approach is not
ideological, but rooted in the economics of information. The core
of the argument is that students (in sharp contrast with school
children or people with complex medical problems) are well-informed,
or potentially well-informed, consumers, and hence better able
than planners to make choices which conform with their interests
and those of the economy. Though that proposition is robust for
many students, there is an important exception: people from poorer
backgrounds might not be fully-informed, with major implications
for access, discussed below.

On the supply side, central planning, whether or
not it was ever desirable, is no longer feasible. Technological
change has led to more universities, more students, and much greater
diversity of subject matter. The myth that all universities are
the same and should be funded equally is no longer credible. In
principle, differential funding could be implemented by an all-knowing
central planner, but the problem is too complex for complete reliance
on that mechanism: mass higher education needs a funding method
in which institutions can charge differential prices to reflect
their different costs and objectives.

In contrast with central planning, a competitive
environment creates incentives for universities to be more responsive
to demand from student and employers. Such competition needs to
be supported by an effective system of quality control.

Barr, Nicholas (2010a), Paying for higher
education: What policies, in what order?, Submission to the
Independent Review of Higher Education Funding and Student Finance,
http://econ.lse.ac.uk/staff/nb/Barr_HEReview100215.pdf

Barr, Nicholas (2010b), A properly designed
"graduate contribution" could work well for UK students
and higher education - even though the original "graduate
tax" proposal is a terrible idea, http://blogs.lse.ac.uk/politicsandpolicy/?p=3737